Focus on Economic Data: The Federal Reserve and Monetary Policy, April 27, 2011

INTRODUCTION

The Federal Open Market Committee (FOMC) of the Federal Reserve System (Fed) meets approximately every six weeks to determine the nation's monetary policy goals and, specifically, to set the target for the federal funds rate (fed funds rate). The fed funds rate is the interest rate at which banks lend their balances at the Federal Reserve to other banks, usually overnight.

The FOMC has maintained the target federal funds rate at a range of 0 to 1/4 percent since its December 16, 2008 meeting. The fed funds rate has been kept at this historically low level due to over a year of low and often negative real GDP growth, significant numbers of non-farm employment losses and very high unemployment.

This lesson focuses on the April 28, 2010, press release by the Federal Open Market Committee on the current Federal Reserve monetary policy actions and goals.

TASK

Explain the meaning of the December 14, 2010, Federal Open Market Committee decision concerning the target for the federal funds rate.

Identify the current monetary policy goals of the Federal Reserve and the factors that have recently influenced monetary policy goals.

Identify the current actions taken by the Federal Reserve to achieve its monetary policy goals.

Explain the intended effects of open market operations.

PROCESS

First, a Little Recent History Review:

On December 1, 2008, the Business Cycle Dating Committee of the National Bureau of Economic Research (NBER) declared that the U.S. economy reached a peak in the business cycle in December, 2007, and a recession had begun.

At its December 8, 2008, meeting, the Federal Open Market Committee established the target for the federal funds rate at a range of 0 to 1/4 percent. This historically low fed funds rate target was aimed directly stimulating the economy through lower interest rates. The Fed has maintained at this low level for the federal funds rate to this time.

On September 20, 2010, the Business Cycle Dating Committee of the National Bureau of Economic Research determined that a trough in business activity occurred in the U.S. economy in June, 2009, and that the recession had ended..

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What did the FOMC have to say, more than two years after pushing its primary tool down to a record low in order to reduce interest rates and stimulate credit markets?

Remember, the primary monetary policy goals of the Federal Reserve, as established by the Employment Act of 1946, are to "promote maximum employment, production, and purchasing power." In other words, policies should create jobs, increase output, and keep the price level stable.

The FOMC announced, "Information received since the Federal Open Market Committee met in March indicates that the economic recovery is proceeding at a moderate pace and overall conditions in the labor market are improving gradually."

The FOMC cited these highlights, "Household spending and business investment in equipment and software continue to expand. However, investment in nonresidential structures is still weak, and the housing sector continues to be depressed. Commodity prices have risen significantly since last summer, and concerns about global supplies of crude oil have contributed to a further increase in oil prices since the Committee met in March."

What about inflation? The FOMC added, "Inflation has picked up in recent months, but longer-term inflation expectations have remained stable and measures of underlying inflation are still subdued."

The FOMC then commented on its progress toward achieving its macroeconomic goals - fostering maximum employment and maintaining price stability. "The unemployment rate remains elevated, and measures of underlying inflation continue to be somewhat low, relative to levels that the Committee judges to be consistent, over the longer run, with its dual mandate. Increases in the prices of energy and other commodities have pushed up inflation in recent months."

What does the FOMC expect in the near future? "The Committee expects these effects to be transitory, but it will pay close attention to the evolution of inflation and inflation expectations. The Committee continues to anticipate a gradual return to higher levels of resource utilization in a context of price stability."

"To promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to continue expanding its holdings of securities as announced in November. In particular, the Committee is maintaining its existing policy of reinvesting principal payments from its securities holdings and will complete purchases of $600 billion of longer-term Treasury securities by the end of the current quarter. The Committee will regularly review the size and composition of its securities holdings in light of incoming information and is prepared to adjust those holdings as needed to best foster maximum employment and price stability."

The FOMC federal funds rate action was to "maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels for the federal funds rate for an extended period."

The FOMC announcement conclusion, "The Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to support the economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate."

What Will the Fed Look For?

Figure 1, below, shows the recent history of U.S. real growth of gross domestic product (GDP).

Figure 2, below, shows the recent history of monthly U.S. unemployment rates.

U.S. output is increasing, although at a slower rate than in 2010. The U.S. unemployment rate remains very high. Look again at Figures 1 and 2, specifically at the time period of the recession, December, 2007 through June, 2009.

The FOMC has kept the federal funds rate target at a very low level of 0 to .25 percent during the recession and to the present time, but the economy continues to recover very slowly. Thus, the Fed continues a low interest rate policy that "accommodates" growth. QE2 (the second round of quantitative easing), purchases of almost $800 billion in securities, intended to provide more market liquidity, will end in June, 2011.

Is there a threat of inflation? Take a look at the recent history of changes in the price level, as measured by the CPI-U, Figure 3, below. The majority of the increases in the price level for the past two months have been energy and food prices.

If you leave out the highly volatile energy (especially gasoline) prices over this time period, there has been very little inflation and occasionally some concern about the prospects for deflation. Recently, many observers have feared a recurrence of inflation, driven by energy prices and continued government budget deficits.

Are you worried about inflation?

Recent History of the Federal Funds Rate

At its April 27, 2011 meeting the FOMC decided to keep the target for the federal funds rate at the same level that was first established in December, 2008. Figure 4, below, shows the history of the federal funds rate from 1990 to the present. Note the periodic increases and decreases, as the FOMC has sought to influence interest rates to rise and fall in order to reduce inflationary pressures, stimulate growth, or just to keep the price level stable.

What Are the Monetary Options?

What can the Fed do with its traditional tools to stabilize the economy?

How would each of the above policy tools (actions) impact the economy?

CONCLUSION

This FOMC monetary policy announcement began with a quick assessment of the current economic conditions as, "the economic recovery is proceeding at a moderate pace and overall conditions in the labor market are improving gradually."

The current monetary policy continues to be "accommodative." Low interest rates and other policies to encourage lending and investment are focused directly on the Fed's goals to promote economic growth and full employment.

The FOMC federal funds rate action was to "maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels for the federal funds rate for an extended period."

The continuing question is "how long is the extended period?"

In his first-ever press conference associated with a monetary policy announcement, Fed Chairman Ben Bernanke said that the Fed has revised downward its growth estimate for 2011 to just over three percent and that the recovery was proceeding at a “moderate pace,” a step back from his characterization that it was on “firmer footing” in the previous month. “The pace of improvement is still quite slow and we are digging ourselves out of a very, very deep hole,” Bernanke added.

The Fed revised its projection of inflation in 2011 inflation dues to higher oil prices. The projection for "core" inflation was increased just slightly. Bernanke added that he did not think the oil price increases would cause more serious overall price level increases.

Bernanke reaffirmed that the Fed is ready to act if economic growth slows or if the threat of inflation worsens.

ASSESSMENT ACTIVITY

Next, complete the essay question below on the interactive notepad.

1. What is the purpose of the FOMC's target for the federal funds rate?

EXTENSION ACTIVITY

Idea #1. The Federal Reserve Bank of Philadelphia has published an online activity called "The Case of the Gigantic $100,000 Bill." In this lesson, students participate in a demonstration of the money creation process using a large $100,000 bill. Expansions of the money supply caused by successive deposits and loans are traded on the board so that students can observe the process. Students learn to calculate the upper bound of the money creation process using the simple money multiplier.

Idea #2. The Federal Reserve Bank of San Francisco publishes a website called "The Economy: Crisis and Response," with information about the Fed's policies during the recession and banking crisis.

Description: "The financial market turmoil that began in 2007 led to a severe global economic downturn. The causes of the crisis, the effects on global financial markets, and the spillover to the economy are examined here."